(The following is adapted from the new book, Jonathan Clements Money Guide 2015.)
Reviewing your investment strategy for 2015? Start with these five steps:
1. Calculate your portfolio’s current split across stocks, bonds, cash investments and alternative investments. This basic asset allocation is the key driver of your portfolio’s risk and potential return. Many of the big mutual fund companies and brokerage firms have account aggregation software that allows you to pull in information from outside accounts, making it easy to figure out your overall investment mix.
2. See if any individual stock positions account for more than 5 percent of your stock portfolio’s value. It’s dangerous to bet too heavily on any individual stock — and that’s doubly true if it is your employer’s stock.
(MORE: How to Avoid Pinching Pennies in Retirement)
3. Find out the annual expenses for all your funds. If any charge more than 1 percent of assets per year, look for lower-cost alternatives — and seriously consider market-tracking index funds.
4. Look up how your stock funds performed in 2008 and how your bond funds performed in 2013. Are you mentally prepared for losses like that? If not, you might adjust your portfolio now, before you find yourself panicking and selling in the midst of a market decline.
5. Figure out how much cash you will need from your portfolio over the next five years. Then, make sure that money isn’t in stocks or riskier bonds.
Heading Off Short-Term and Long-Term Risks
The most important factor when it comes to investment risk: How far off do your goals lie?
If you have five years or less to invest, the biggest risk is short-term market declines, so you should probably focus on cash investments (such as savings accounts, CDs and money-market funds) and shorter-term high-quality bonds.
If you have more than five years to invest, you’re likely more concerned with making your money grow. In pursuit of higher investment returns, you might buy riskier bonds, stocks and possibly alternative investments (such as real estate, gold and commodities). Here, the big risk is failing to beat back the twin threats of inflation and taxes.
Smart tax management, especially the use of retirement accounts, can greatly reduce the threat from taxes. To outpace inflation, you’ll need to look to bonds and especially stocks.
(MORE: 15-Minute Portfolio Checkup)
Over the long run, U.S. stocks have delivered close to 7 percentage points a year more than inflation. But these days you probably shouldn’t expect long-run returns on a globally diversified portfolio that are more than 3 to 4 percentage points a year above inflation.
Asset Allocation Guidelines
A portfolio that includes some combination of the four major assets — stocks, bonds, cash investments and alternative investments — can offer the same reward as one that doesn’t but with less dramatic swings in your portfolio’s value.
Your precise mix of stocks, bonds, cash and alternative investments will be driven by your goals and individual circumstances. Still, it’s helpful to have some guidelines. For retirement savings, one rule of thumb suggests that you take 100 and subtract your age to get the percentage of your portfolio to hold in stocks: age 55 = 45 percent in stocks.
As rules of thumb go, it isn’t bad. But I would tweak it. Among retirees, I would peg stocks at a minimum 30 percent. If you have less than that, you leave yourself vulnerable to long-run inflation. Indeed, with the right portfolio design, I think a 50 percent stock allocation may make more sense for retirees.
I don’t think alternative investments are a necessary part of a portfolio. But if you want a position in a mix of, say, gold stocks and real estate investment trusts, I would probably cap that position at 10 percent of your portfolio.
The Advantages of Investing With Index Funds
You might focus on capturing the market’s return at the lowest possible cost — by purchasing market-tracking index funds, which buy many, or all, of the securities that make up a market index in an effort to match that index’s performance.
I’m a huge fan of indexing, whether with index mutual funds or exchange-traded index funds (ETFs). Extraordinarily few investors manage to beat the market over the long term, so why try?
Admittedly, by purchasing index funds, you give up all chance of beating the market. But you also eliminate the risk that you’ll fall far behind. As an added bonus, index funds tend to be highly tax-efficient, because they don’t actively trade their portfolio and thus are slow to realize capital gains.
Index Funds Vs. ETFs
Which are better, index mutual funds or ETFs?
ETFs usually have lower annual expenses than comparable index mutual funds. And ETFs come in more varieties, so they may be your only choice if you want a more specialized index fund. In addition, ETFs have the potential to be more tax-efficient than index mutual funds.
So ETFs will often be the better choice if you plan to invest a large sum and leave it there for many years. But that doesn’t describe the behavior of many ordinary investors. If it doesn’t sound like you, I think you’ll likely find that index mutual funds make more sense, because you’ll avoid the trading costs involved with frequent ETF purchases.
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